Three Stocks Whose Time Has Come
01/26/2010 9:29 am EST
Where the economy sits in the recession-recovery cycle determines which sectors are most likely to yield the biggest profits.
Are you in the right sectors of the stock market for this point in the economic recovery?
Solid data stretching back to 1945 argue that certain industries and sectors outperform during specific stages of any economic recovery. (The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research Services. His 1996 book, Sector Investing, is still the best resource on the subject.)
My first rule of investing is, "Put every trend you can on your side." Neglecting what we know about which sectors thrive when is, in my opinion, wasting an asset that could help you make bigger profits.
Stovall divides the economic cycle into four stages:
- Early recession - You should remember this stage vividly. Consumer sentiment ranges from fear to terror, industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well—relatively, at least—during this stage include services, near the beginning; utilities; and, near the end of the stage, cyclicals and transports.
- Full recession - Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage, historically, have been cyclicals and transports, at the beginning of the stage; technology; and, near the end, industrials.
- Early recovery - Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials, near the beginning of the stage; basic materials; and, near the end, energy.
- Late recovery - Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and, near the end of the stage, consumer staples and services.
I think it's pretty clear that we're in the early recovery stage. (And I hope that we stay there. No backsliding, Mr. Economy.)
One Company's Recovery
To confirm that opinion, I took a look at the performance of the sectors in the Standard & Poor's 500 Index this year, through January 20.
Health care led the bunch with a 5.03% gain since the beginning of the year. Much of that wasn't related to the economic cycle at all, but was a result of a rally in the sector based on the declining prospects for the Obama administration's health care plan. The financial sector was in second place at 4.95%. That, I think, was a result of the origins of this recession in the near collapse of the financial system. I wouldn't discount this when planning portfolio allocations right now, but that's a topic for another column.
Then came the sectors I'd expect to see in the early-recovery stage: Industrials at 4.29%, energy at 2.52%, and materials at 2.12%.
Trailing sectors included consumer staples (0.75%), consumer discretionary (0.6%), information technology (-0.11%), utilities (-0.35%), and telecommunications services (-6.42%).
To see why industrial stocks historically do so well during the early stages of a recovery, take a look at Precision Castparts (NYSE: PCP), a company that makes components for jet engines and industrial gas turbines.
After holding revenue almost constant in its fiscal 2008, Precision's prospects turned increasingly grim during the latter half of fiscal 2009 and the first two quarters of fiscal 2010 (the company's fiscal year ends March 31). Revenue fell to $1.62 billion in the third quarter of fiscal 2009, then to $1.60 billion in the fourth quarter, $1.38 billion in the first quarter of fiscal 2010, and $1.30 billion in the second quarter.
The company announced third quarter results for fiscal 2010 on Thursday. Revenue hit $1.37 billion. That's not a huge increase from the second quarter's $1.30 billion, but it's a move in the right direction.
Earnings per share showed a similar rebound—to $1.61 a share, up from $1.54 in the previous quarter—as the company cut costs and saw margins increase to 25.8% from 23.3% in fiscal 2009. (For more on why companies see rising profit margins in the early stages of a recovery even as unemployment stays high, see this recent edition of Jubak's Journal.)
In its earnings conference call last week, Precision's management said that in the quarters ahead, it expects unit sales to pick up as the airline and utility industries speed up capital spending. Sales of replacement parts should also rise as airlines fly more miles and need to do more maintenance. And finally, Boeing's troubled 787 Dreamliner made its first test flight on December 15. At that point, Boeing had 840 orders for the planes.
All of this leads Standard & Poor's to project 11% sales growth for Precision in fiscal 2011. Operating margin is expected to climb to 26.4% for fiscal 2010 as a whole and then to 27% in fiscal 2011. Projected earnings of $7.75 a share in fiscal 2011 would be 12.5% higher than they were in fiscal 2008, before the bottom fell out of the economy.
My only hesitation with Precision Castparts right now is that the stock has roughly doubled from its March 2009 bottom. Maybe it will pull back enough in what is shaping up as a decent correction for me to find a buy compelling.
Three Stocks to Buy Now
But in the meantime, let me give you the names of three other industrial stocks, in alphabetical order, which you can use to put sector timing to work for your portfolio. (And they're closer to an attractive buying price.)
1) Honeywell International (NYSE: HON) - The world's largest maker of small jet engines, cockpit controls, and climate control equipment, Honeywell also operates business units in specialty materials and automotive products such as turbochargers. Those latter two units provide some of the company's most promising near-term growth, with S&P projecting 2010 revenue growth of 9% in the automotive unit and 5% in the specialty materials business.
A big charge for the company's pension plans will depress earnings in 2010. Absent that one-time charge, earnings are expected to grow 11% in 2010. As of the January 21 close, the shares traded at 12.9 times adjusted 2010 earnings per share.
2) Johnson Controls (NYSE: JCI) - Johnson Controls is not only a very diversified industrial company, but one with the diversity in the right places to take advantage of the early-recovery stage of the economic cycle.
About 42% of its revenue comes from the company's automotive interiors business. In September, the company announced a joint venture with Beijing Automotive Industry that will use an existing 420,000-square-foot plant in Beijing to operate Johnson Controls' first automotive seating and interior operation in China. Customers will include Chrysler, Isuzu, and Peugeot. In August, a joint venture in India, Tata Johnson Controls Automotive, began manufacturing seats and related components for Ford.
In addition, 44% of Johnson Controls' revenue comes from a building efficiency business that sells heating and cooling equipment and services.
The company also has a huge lead auto battery business and a promising joint venture to build batteries for hybrid vehicles. (See my blog post for more on why you should have battery stocks in your portfolio.) The company is projected to show earnings of $1.53 a share for its fiscal 2010, which ends in September. That would be a big improvement on fiscal 2009's loss of 31 cents a share.
3. Nucor (NYSE: NUE) - Talk about a turnaround. Despite a 50% sales slide for Nucor in 2009, S&P has projected a 29% increase for 2010 on higher growth for the economy as a whole, a slowing rate of decline in non-residential construction spending, and inventory rebuilding at steel distributors that have spent most of 2009 selling down inventory.
Thanks to a rigorous culture of cost control, Nucor remained cash-flow-positive even during the 2009 downturn and should see margins increase with a return of sales volume in 2010. S&P projects 2010 earnings of $3.39 a share for 2010, quite a recovery from the $1.12 loss projected for 2009. At the January 21 closing price, the shares traded for 13.5 times projected 2010 earnings per share.
I can't resist mentioning one other industrial stock, Polypore International (NYSE: PPO), although I have almost no hope of catching a good price for it in any of my portfolios. The stock has moved up like a rocket on news that this maker of microporous membranes used in filtration and (this is the part that interests me) in batteries had renewed its contract with Exide Technologies (Nasdaq: XIDE). Exide is Polypore's biggest battery membrane customer and fears that the agreement would not be renewed had punished Polypore's stock.
But I missed buying shares on the bounce because this stock moves so fast. Maybe you'll have better luck in timing a buy. At a closing price of $13.21 Thursday, the stock was closing in fast on its 52-week high of $14.10. The 52-week low is at $2.38.
At the time of publication, Jim Jubak owned shares of the following company mentioned in this column: Johnson Controls.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.